How Do I Perform a Credit Risk Assessment?

Geri Terzo
Geri Terzo
An individual’s credit history is a good indicator of their credit risk.
An individual’s credit history is a good indicator of their credit risk.

Credit risk may be an individual analysis of someone's own personal financial history, health, and future. In some cases, a credit risk assessment can be a calculation that is achieved using an online tool. An assessment can also be assigned to a potential borrower by the lender. They allow the lender to gauge the likelihood that a loan will be repaid. Also, an investor might make a credit risk assessment before taking a chance on financial securities.

There are different behaviors and criteria that can be used to arrive at a credit risk assessment. Some of those patterns include timeliness in making mortgage payments. The more frequently that a debtor is late on a mortgage loan or any other house payment, such as rent or a second mortgage, the more heavily this component weighs on a credit risk assessment. Other factors that influence an individual's credit risk include personal bankruptcy filings, foreclosures, or liens against property or other assets. All of these components might be entered into fields on an online calculator in order to quantify credit risk.

An individual with the highest return on a credit risk assessment is the most likely to receive loan financing at the most attractive interest rates possible. Salary and other revenue streams also influence the type of loan that may be obtained. Someone scoring in the middle of an assessment might be awarded a loan but may have to pay a higher rate of interest. A person who scores at or near the bottom of the risk assessment spectrum may not be able to obtain financing at all.

In the stock market, an investment into bonds is often considered a safe, conservative way to direct money. High-quality, investment-grade bonds, as rated by outside ratings agencies, are among the safest investments. There are risky bonds, however, and subsequently, assessing the risk of these debt instruments before investing is recommended.

High-yield bonds pay higher interest rates than traditional bonds, but issuers also have a greater risk of defaulting on loans. Third-party ratings agencies assign grades to bonds issued by corporations, governments, and municipalities, and analysts can make changes to those ratings as appropriate. Investors can better understand the type of risk that a bond carries by finding out the rating assigned to the debt. Also, risk can be assessed by reading any public regulatory documents that a bond issuer might file, such as a prospectus, with a governing body in a region.

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Discussion Comments

sunshine31

@GreenWeaver -I know that banks also look at business loans the same way. If for example, you are looking to finance a business and this is a startup restaurant you will probably have a hard time getting a loan because banks know that the average restaurant startup has a 95% failure rate so they are really reluctant to extend a loan for this purpose.

This is why a lot of borrower’s that have businesses often take out home equity lines in order to finance their business. This type of loan product really lowers the bank’s initial risk considerably because if the borrower defaults, the bank can seize the borrower’s home or force the sale of the home in order to get paid.

With a regular business loan this is not the case which is why banks usually warm up to the idea of a home equity line instead because their operational risk assessment is much lower.

GreenWeaver

@Crispety - I think that a lot of banks are carefully considering the borrower’s profile in the credit risk analysis, but there could also be outside factors that may raise the bank’s risk with a given borrower.

For example, a few years ago I was looking to buy a vacation home and I was interested in a beachfront condo. I was already preapproved for the mortgage but I did not know that the bank’s financial risk management department's rating given to a condominium complex in which I was buying my home from was deemed too risky for them.

They stipulated that when offering mortgages for condominiums they consider the number of owner occupants in the building as well as the financial health of the home owner’s association. They also consider the percentage of foreclosures in the building as well.

Well, my condo failed on all accounts because it had less than the required 50% occupancy rate and the foreclosure rate at the time was 25% which also meant that the association was not getting all of their dues in on time. I had to end up paying cash and most of the units in the building that were left were bought by investors because the banks would not issue loans on this property.

Crispety

@Icecream17 - The credit score is probably the most important aspect of a borrower’s profile, but so is income with respect to the borrower’s debts. If a borrower has excellent credit because he or she pays the bills on time then their credit rating could be high, but they could also be carrying a lot of debt that will not allow the bank to extend the best rates for that customer.

Banks always consider how much debt you already have and how much you can take on before it becomes a problem. For example, many financial advisors say that you should not have more than 28% of your household income be used to pay your expenses related to your home.

Banks realize that when this percentage goes beyond 28% that the borrower might be stretched too thin and will not be able to make the payments comfortably. This is also considered in the overall credit risk models.

icecream17

I think that when a bank assesses its credit risk analysis of a prospective borrower they really look at their credit risk rating. A person’s credit rating really tells a lot about their financial habits and tells the bank whether the borrower is credit worthy or not. I know that many banks will consider people with credit rating scores of 740 or above as optimal, and will usually give these people the very best rates

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    • An individual’s credit history is a good indicator of their credit risk.
      An individual’s credit history is a good indicator of their credit risk.